Judging whether or not your business can afford a commercial loan comes down to three questions. Can you pay the loan; will you pay the loan and what will happen if you can’t pay the loan?
There is some math involved in answering these questions but knowing a few figures can help you evaluate your financial performance and judge whether taking out a commercial loan is worth it.
To answer the first question, can you pay the loan, you need to calculate your Debt Service Coverage Ratio (DSCR). This figure tells you the amount of money you have on hand each year to pay your debts. Your DSCR is calculated by subtracting your monthly income from your monthly expenses and multiplying the result by twelve. This gives you the amount of money you have available each year. Then you estimate what the cost of the potential loan is and divide that into the first number. Potential lenders consider a DSCR of 1.25 to be reasonable. If your DSCR is lower than 1.25, you probably cant afford to take out a loan. Knowing your DSCR helps you evaluate if you can afford any potential loan on a yearly basis.
To answer the second question, you need to know the ratio of your income vs. your outstanding debt obligations is (Debt to Income ratio or DTI). Knowing this figure will help you judge if you will be able to pay back any loan in the long run. To calculate your DTI add up all your outstanding personal and business debts, divide it by your monthly income and multiple the result by 100. This number clarifies whether your income exceeds your debts or whether your debts exceed your income. A DCI greater than 36 indicates you should avoid additional borrowing. This number gives you a sense of your financial performance on a monthly basis and indicates whether you will be able to keep up with your loan payments.
But even knowing your DSCR and DTI doesn’t answer the fundamental question. Is taking out a commercial loan worth it?
You may need to consult an accountant or business advisor in order to answer this question. The answer involves a nuanced process known as Loan Performance Analysis. In layman’s terms this process gives you a sense of the risks of borrowing versus the rewards of additional investment. Look at your current profitability and compare it to the revenue any new investment might produce. It is important that you are realistic during this process. Optimistic projections about potential revenue wont clarify the risks of additional borrowing. Consider multiple scenarios throughout this process as well in order to get a better understanding of your situation. Loan Performance Analysis may be more subjective than calculating your DSCR or DTI but it will further clarify whether getting a loan is actually worth it.
Plan ahead and understand the impact defaulting may have on your business
Life happens and things could change rapidly in your business. Even the most conservative projections during loan-performance analysis may not reflect the reality of a potential disaster. You should always be aware of the risks involved in defaulting on any potential loan. Do you have enough collateral to cover the loan? If not you may be personally responsible for paying off the remaining balance. Carefully consider whether you are willing to risk your personal property before taking out any loan. However knowing these figures, your DSCR, DTI and performing Loan Performance Analysis will give you a good sense of whether taking out a loan is worth it.
Level 4 Funding LLC Private Hard Money Lender
Arizona Tel: (623) 582-4444
Texas Tel: (512) 516-1177
Dennis@level4funding.com NMLS 1057378 | AZMB 0923961 | MLO 1057378
22601 N 19th Ave Suite 112 | Phoenix | AZ | 85027
111 Congress Ave |Austin | Texas | 78701
About the Author: Dennis has been working in the real estate industry in some capacity for the last 40 years. He purchased his first property when he was just 18 years old. He quickly learned about the amazing investment opportunities provided by trust deed investing and hard money loans. His desire to help others make money in real estate investing led him to specialize in alternative funding for real estate investors who may have trouble getting a traditional bank loan. Dennis is passionate about alternative funding sources and sharing his knowledge with others to help make their dreams come true. Dennis has been married to his wonderful wife for 42 years. They have 2 beautiful daughters 5 amazing grandchildren. Dennis has been an Arizona resident for the past 40 years.